August 10, 2021

The Ultimate Diversifier: What Real Assets Are Gaining in Allocator Portfolios

Infrastructure such as bridges and tunnels, plus farmland and other natural resources, is winning new favor.

Reported by Larry Light

Art by James Yang

Mix low correlation to standard assets (read: stocks and bonds) with inflation protection, a decent income stream, and long-term price appreciation, and you’ve got a thriving investment trend. We’re talking about real assets here. They are the ultimate diversifier.

Some definitions of real assets include real estate, which is certainly a solid, non-correlating investment class on its own. But more often the real asset rubric excludes structures where people live, work, and shop. By that delineation, real assets fall into two areas: 1) natural resources (timberland, farmland, metals and mining, and water), and 2) infrastructure (roads, bridges, airports, and railroads, along with cell towers and data centers). There’s an argument to be made that these kinds of assets are less dependent on the economy than is real estate. Office occupancy shrinks in a recession, while people still need water.

For publicly traded equities in this realm, real assets had a global value of $4.3 trillion, a 2017 report from asset management firm Brookfield calculated. Natural resources were about three-quarters of that. These days, the figure would be much higher, of course. In the firm’s separate report on real assets as a diversification mechanism, Brookfield noted that real assets tend to increase in value as replacement costs and operational efficiency rise over time. Further, the paper stated that cash flow from real assets can furnish predictable and steady income streams for investors.

Real assets, to be sure, carry the weakness of low liquidity, perhaps even lower than real estate. Direct ownership of real assets, while in vogue among large pension funds, is not for everybody: You can’t readily sell a few thousand acres of farmland; the market for this acreage is smaller than for office buildings. Also, unlike financial assets, real assets come with high operating and maintenance costs. Someone has to till the soil, keep it fertilized, and ensure it’s irrigated. That’s why owning stock in companies that own this stuff often is a better course for investors, noted Jim McDonald, Northern Trust’s chief investment strategist.

Infrastructure stocks have done OK of late but aren’t winning any gold medals. Lately, the stock market overall has performed better than infrastructure shares. For this year through mid-July, global infrastructure stocks returned 3.7%; the overall market—namely, the MSCI All-Country World Index—outpaced them. Infra trailed the index by 4.9 percentage points. That result for infra is likely due to lingering problems in transportation, a business that has struggled with the pandemic. This may change with Congress poised to pass a massive infra build-out measure, worth $1 trillion.

Natural resources, in high demand for everything from home construction to food, have done better. FlexShares Morningstar Global Upstream Natural Resources Index exchange-traded fund (ETF) this year through last Friday had gained 17.2%. In the fund, which Northern Trust sponsors, agriculture, energy, and metals and mining each have 30% of the portfolio, with the remainder split between timber and water.

Real assets are a small yet growing piece of US institutional investors’ portfolios, although views on these vary. At the $14.4 billion School Employees Retirement System (SERS) of Ohio, in fiscal 2020, just 2.5% was allocated to infra. CIO Farouki Majeed said he likes the 10% yield he can get from these assets. And, over the next five years, he foresees a 6% to 7% annual return on them.

His approach is similar to that of Monte Tarbox, executive director, investments, at the $12 billion National Electrical Benefit Fund, a multiemployer program for electrical workers. He has just 1% in infra, although he expects to increase that by a percentage point each year over the next decade. “They move to the beat of a different drummer,” he said of the wide-ranging panoply of infra assets. “Data centers are on a tear” and have been good for his fund. Both investment chiefs appeared at our on the subject of real assets.

Let’s zoom in on the two branches of real assets:

Infrastructure

This is a hot area nowadays, even if stock prices don’t yet reflect that. First, there’s the infra bill before Congress. Coupled with that is a worldwide push for green energy and upgrades to digital equipment, according to a Nuveen research paper. Seeking more environmentally friendly energy generation, Nuveen sees vast opportunities “to invest in the clean energy transition trend across generation, transmission, and storage of renewable energy, as well as with renewable diesel and other lower-carbon fuels beyond the electrification trend.” Beyond that, the continuation of remote work and the 5G rollout are bolstering the demand for upgrades in digital infrastructure. “These are long-dated assets” that will produce steady returns over time, said Rich Sega, Conning’s global chief investment strategist.

More broadly, the rapid deterioration of roads, bridges, tunnels, and the like is calling for government attention as never before. In Washington, the bill, now under Senate consideration, dedicates $15 billion over five years with an increasing amount of money each year—from $2.4 billion next year to $3.25 billion in fiscal year 2026—for grants to clean up drinking water by removing lead-contaminated pipes. Just as bad, the pipes, whether lead or not, too often leak. By the estimate of the American Society of Civil Engineers, 6 billion gallons of treated water are lost every day due to water main breaks. Then comes the really big infra shortfall: 43% of US public roads are in poor to mediocre condition.

All this enthusiasm has attracted much private investment in the area, starting last year, as talk started to swell about finally doing something to fix crumbling infra. Large partnerships targeted at institutional investors have raked in new money. A record 328 infrastructure funds are currently in the market globally, having raised $238 billion, a second-quarter report from data firm Preqin indicated. While their returns are on the low side, so is their risk, the firm pointed out. The biggest such fund to close in this year’s first half was Copenhagen Infrastructure Partners ($8.42 billion), followed by BlackRock’s renewable power fund ($4.8 billion), Preqin reported.

On top of that, infra debt funds are booming, too. Such vehicles raised $20.1 billion last year, up 18% from 2019 and 16 times what was collected 10 years earlier. The risk level for this debt is low, declared Jérôme Neyroud, head of infrastructure debt at Schroders Capital, in a research note. Losses are “a fraction” of those in high-yield corporate bonds, he said.

Canadian pension programs, as is their wont, are heavily into infra. The Ontario Teachers’ Pension Plan, for instance, has 8% of its (as of year-end 2020) in infrastructure investments.

Unfortunately for stock pickers, in terms of investing in construction companies that will do the infra build-out, a lot of the gains have been priced in. Construction equipment giant Caterpillar has seen its shares vault 27% over the past year. The market, however, lately appears to think that it got ahead of itself. The current price of $209 as of Monday, is down from the $244 peak in May.

Natural Resources

This diverse arena has the virtue of being in increasing demand, as the world’s population grows and also as world incomes expand. “This is a play on a rising global middle class,” Northern Trust’s McDonald remarked.

For large institutions such as Canadian pension funds, this is an enticing investing area. Canada’s Public Sector Pension Investment Board (PSP) devotes almost 5% of its US$162 billion portfolio to natural resources, two-thirds of it in agriculture, most of the rest in timber. “A high component of land, water, or biological assets typically underpin[s] our investments and add[s] to downside protection,” the fund wrote in its annual report.

For the fiscal year ending this past March, natural resources returned 10.6%. Supply bottlenecks stemming from the aftermath of pandemic lockdowns was a factor here, certainly. But the five-year annual return was a pretty solid 9.0%. Among its many international holdings scattered around the world is Webster Ltd., an Australian farm company that specializes in walnut growing and organic cattle husbandry.

Snapshots of a couple of investment types illustrates their promise:

Farmland. This is “resilient through economic cycles,” a Nuveen research paper observed. Farmland did well during the pandemic, amid robust food buying in the West and surging demand from China—especially for grains and oilseeds. Environmentally oriented investors also are on the hunt for sustainable farm production, which creates another positive push for prices. In addition, Bank of America Private Bank maintained that “global consumption trends and demand for farm exports point to a positive long-term outlook.” Further, BoA stated, “farmland rents and values have remained steady, supported by low interest rates.” Farmland sports a total value of $2.7 trillion and has delivered 11% annual returns since 1936.

The largest individual owner of farmland is Bill Gates, who owns more than 200,000 acres. Meantime, funds exist that also own farm property and benefit from selling crops, meat, milk, and other commodities. Gladstone Land, for instance, is a real estate investment trust (REIT) that, since the March 2020 market low, has more than doubled in price. It owns 141 farms, across 13 states, worth $1.2 billion as of May. Among US pension plans, New Mexico State Investment Council (NMSIC) and the Florida State Board of Administration (SBA) have investments in farms.

Timberland. Lumber’s price spiral earlier this year, prompted by furious home construction and shutdown of sawmills, was temporary. The pandemic triggered a homebuilding and renovation boom in the US and other countries as people spent more time than ever in the house. Furthermore, forest products such as tissue paper, food delivery packaging, and e-commerce shipping boxes, all used in at-home consumption, also did well.

Timber is the epitome of a long-term investment. From a sapling, a tree can take two or three decades before it is ready for cutting. In the meantime, woodland owners can get some income from selling water rights beneath their forests and also charging hunters to use the land. But the major source of income is from harvesting the trees. Northern Trust’s McDonald said up to 10% of a property’s timber is cut per year, so plenty more exists to be felled in the future. Aside from owning the land outright, the iShares S&P Global Timber & Forestry Index ETF is a popular way to invest in the industry globally. Since the March pandemic low, the price has vaulted 87% and, over 10 years, is up an annual 10.7%.

Whether investors are plugging dollars into asphalt or alfalfa, it appears that a pretty decent opportunity awaits.